What is the funding rate? How do you use it in trading?
Today I would like to briefly comment on the “funding rate,” which is a factor in making trading decisions in virtual currencies. The funding rate indicates the “market trend,” and if you do not keep an eye on it, you may end up making unfavorable trades in terms of risk-reward.
What is the Funding Rate?
Let’s start by explaining what the funding rate is. To put it simply, it is “interest calculated backwards from position trends.” In other words, the supply and demand balance can be understood by looking at how much interest you will be charged or received on long or short positions.
For a detailed explanation, please see the excerpt from Bybit’s explanation.
(*Bybit calculates the funding rate from two indexes, the interest rate and the premium index, but since this calculation is unique to Bybit, there may be other factors and variables in the calculation method depending on the exchange.)
“The funding rate is made up of two parts: the interest rate and the premium index.”
Interest Rate (I)
Every contract traded on Bybit is composed of a base currency, such as BTC, and a conversion currency, such as USD. The interest rate is a function of the interest rate between these two currencies. In BTCUSD, it is the difference between the borrowing cost of BTC and USD. The BTC lending rate (BTCBON) can be found on the Bybit website in the Index section of the Contract Guide page.
Premium Index (P)
Perpetual contracts can trade at a premium or discount from the market price. In this situation, the Premium Index is used to raise or lower the next funding rate so that the contract remains at the same state it is trading at. On the Bybit website, a historical record of the Premium Index (BTCUSDPI; Premium Index) can be found in the Index section of the ‘Contract Guide’ page.
Funding Rate Calculation
Bybit calculates the Premium Index (P) and Interest Rate (I) every minute, then performs an 8-hour Time Weighted Average Price (TWAP) on the series of minute rates.
The Funding Rate is then calculated using the 8-hour Interest Rate component and the 8-hour Premium/Discount component. A dampening factor of +/- 0.05% is added.
Funding Rate (F) = Premium Index (P) + clamp(Interest Rate (I) – Premium Index (P), 0.05%, -0.05%).
Therefore, ifI-P P) is within +/- 0.05%, then F = P + (I-P) = I. In other words, the Funding Rate is equal to the Interest Rate.
The Funding Rate thus calculated is applied to the trader’s position value to determine the amount of funding fee paid or received at the applicable funding exchange expiry. Even if you explain it in such a complicated way, most people will say they don’t understand it. So you just need to remember the meaning. First, what do you think about the possibility of paying higher interest rates?
“This means that the demand for the currency has increased, and the increased need has made it necessary to pay to go long .”
In terms of BTCUSD, the interest rate on BTC has risen as the demand for BTC has increased. When trading cryptocurrency FX, cryptocurrency traders do not need the actual currency, but only buy and sell price movements (also called exposure). This means that when you buy something, you are borrowing something, so when you buy something that has a higher demand, you will incur an interest burden. If you think about it simply from a supply and demand perspective, it may be easy to understand.
How do you view the funding rate?
First, here is the Bybit funding rate screen. The “Funding Rate” displayed on the screen is a number that allows you to understand the position (in a sense, the interest rate differential) calculated from the supply and demand balance, as explained earlier. If it is displayed as a positive number, it is the interest rate you will pay if you establish a buy position for the currency “BTC” that appears first. If it is displayed as a negative number, you will receive interest if you hold a buy position for BTC
This means that the short position in BTCUSD is getting larger in terms of supply and demand. The interest rate shown here is calculated every 8 hours. The key point is that it is not the interest rate for one day. The interest rate for one day is three times the listed interest rate. As you can see from the screen, this means that you may incur a fairly large interest burden. This is not something to be taken lightly.
How to use the underlying rate in trading?
So, to summarise, let’s look at how you can use the funding rate to your trading. As explained, the more tilted your position is in terms of the funding rate, the larger the payment or receipt will be for taking a position. Therefore, from the perspective of the payer, you would want to liquidate that position as soon as possible before the next calculation time, right?
This is the psychological aspect of having a position on the cost-bearing side, and the direction is a prediction from the interest-bearing side, but there are times when the interest burden is so large that you hesitate to take a position. The higher the funding rate, the larger the swings we can expect in the opposite direction, as the market is already heavily skewed. This is called stop hunting in foreign exchange FX. It’s like killing the stop limit and moving the market. It’s useful to be able to use this price range and decide the timing of your trade.
What to consider when trading with the Funding Rate?
There are some basic points to keep in mind when trading using this funding rate. The first item is “The direction of this trade is contrarian. ”
If the position is biased and the interest burden is large, it means that the trend is leaning in that direction.
That’s why that much interest burden is occurring, so be aware of that point. Therefore, you will need to use technical analysis to find the timing of your entry. You cannot trade on the funding rate alone, so use it only as a secondary indicator.
Although you may enter a trade thinking that the trend has changed, it is common for the trend to go back in the opposite direction. Since this is a contrarian trade, it is important to set a shallow stop loss order.
The ideal trade can win even if you lose nine times, so keep that in mind when trading.
Once you become familiar with the funding rate, it can be very useful to create charts and compare them with market prices.
